Explaining hump-shaped inflation responses to monetary policy shocks

According to conventional wisdom, the output effects of a monetary policy shock commence within months of the shock, while most inflationary effects lag significantly. We demonstrate a simple model that can explain the conventional wisdom and is consistent with profit maximizing price setting decisions by firms, based on the assumption that renegotiating existing contracts is costly. Thus, firms jointly choose both their price and the expected length of time for which that price will hold each time they re-contract. We show that such a 'sticky contracting' assumption, combined with menu costs, generates a hump-shaped inflation response to monetary policy shocks. Copyright © 2007 John Wiley & Sons, Ltd.